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Chapter 27 THE FEDERAL RESERVE SYSTEM AND MONETARY POLICY Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1.

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Presentation on theme: "Chapter 27 THE FEDERAL RESERVE SYSTEM AND MONETARY POLICY Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1."— Presentation transcript:

1 Chapter 27 THE FEDERAL RESERVE SYSTEM AND MONETARY POLICY Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1

2 Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2 The Federal Reserve System as a central bank The discount rate as a tool of monetary policy Open market operations as a tool of monetary policy

3 Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3 Money supply versus interest rate targets Countercyclical monetary policy

4 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 4 Bank note A promissory note, issued by a bank, pledging to redeem the note for a specific amount of gold or silver. The terms of redemption are specified on the note.

5 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 5 In colonial times, before banks printed their own bank notes, our money was simply a collection of foreign currencies.

6 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 6 The first real U.S. money was the Continental Note. Since Congress had no taxing authority, it printed Continental Notes to finance the Revolution. Excessive printing rendered the Continental Note nearly useless.

7 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 7 State-chartered bank A commercial bank that receives its charter or license to function from a state government and is subject to the laws of that state.

8 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 8 EXHIBIT 1GROWTH OF STATE BANKS: 1784–1860 ($ MILLIONS) Source: U.S. Bureau of the Census, Historical Statistics of the United States, 1789–1945 (Washington, D.C.: U.S. Government Printing Office, 1949,) pp. 261–263.

9 Exhibit 1: Growth of State Banks: ($ millions) © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 9 What are some reasons for the rapid growth of state banks? The money supply was inadequate to finance the growing number of farms, factories, and businesses.

10 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 10 Alexander Hamilton proposed a nationally-chartered central bank that would exercise control over the money supply and extend credit to the federal government.

11 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 11 Congress accepted Hamilton’s plan and created the First Bank of the United States in This central bank dampened the inclination of state-chartered banks to overissue notes by demanding that the notes be redeemed in silver and gold.

12 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 12 Nationally chartered bank A commercial bank that receives its charter from the comptroller of the currency and is subject to federal law as well as the laws of the state in which it operates.

13 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 13 When the 20-year charter of the First Bank of the U.S. expired in 1811, advocates of states’ rights in Congress prevailed, and the charter was not renewed.

14 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 14 In 1816 Congress created the Second Bank of the U.S., which again stabilized state banking practices. As with the First Bank, however, political pressure led to the failure of Second Bank of the U.S. in the 1830s.

15 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 15 During the Civil War, Congress passed the National Bank Act, which created a national banking system and the office of the comptroller of the currency, which chartered national banks.

16 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 16 National banks had to buy Treasury Bonds equal to one-third of their capital, and could issue notes only in proportion to their Treasury bond holdings.

17 A Glimpse at History © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 17 In 1907 the highly respected Knicker- bocker Trust Company collapsed. This spurred a run on banks, a credit crisis, and a recession. Congress responded with the Federal Reserve Act of 1913.

18 The Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 18 The Federal Reserve Act of 1913 created the Federal Reserve System (the “Fed”). The Fed has 12 regional district banks that serve as the region’s central bank.

19 The Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 19 Does the president of the U.S. control the Fed? No. Although the Fed was created by and responsible to Congress, the Fed pursues an independent monetary policy that at times may conflict with policies pursued by the president or Congress.

20 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 20 EXHIBIT 2THE GEOGRAPHY OF THE FEDERAL RESERVE SYSTEM

21 Exhibit 2: The Geography of the Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 21 In what Federal Reserve Bank district do you live? What is the reserve bank city for your district?

22 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 22 EXHIBIT 3NATIONAL BANKS AND STATE BANKS 2011 Source: Federal Deposit Insurance Corporation, Institution Directory, 2011 (Washington, D.C.: FDIC, 2011).

23 Exhibit 3: National Banks and State Banks 2011 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 23 How many banks are chartered nationally? Of the 7,519 banks in the country, fewer than 1,400 are chartered nationally.

24 Exhibit 3: National Banks and State Banks 2011 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 24 How many state-chartered banks are members of the Fed? Of the 4214 state-chartered banks in the country, 816 banks are members of the Federal Reserve System.

25 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 25 EXHIBIT 4ORGANIZATIONAL STRUCTURE OF THE FEDERAL RESERVE SYSTEM Source: Board of Governors of the Federal Reserve System, Division of Support Services, Purposes & Functions, 1984.

26 Exhibit 4: Organizational Structure of the Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 26 What is the name of the Fed organization that exercises general supervision over the Federal Reserve Banks (12 districts)? The Board of Governors

27 The Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 27 The Fed’s main charge is to safeguard the proper functioning of our monetary system (money supply, interest rates, and the economy’s price level).

28 The Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 28 Federal Open Market Committee The Fed’s principal decision-making body, charged with executing the Fed’s open market operations.

29 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 29 EXHIBIT 5IDENTIFYING LETTERS AND DISTRICT BANKS

30 Exhibit 5: Identifying Letters and District Banks © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 30 If you look at the seal to the left of George Washington’s picture on a $1 bill and see the letter “L,” in what district bank was that $1 bill issued? San Francisco

31 The Federal Reserve System © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 31 Discount rate The interest rate the Fed charges banks that borrow reserves from it.

32 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 32 EXHIBIT 6BANK TRANSACTIONS TRIGGERED BY BRIAN’S PURCHASE

33 Exhibit 6: Bank Transactions Triggered by Brian’s Purchase © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 33 Why does Brian’s check go to the Atlanta Fed and the Cleveland Fed? One of the functions of a district Fed is to clear checks.

34 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 34 EXHIBIT 7AFROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

35 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 35 EXHIBIT 7BFROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

36 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 36 EXHIBIT 7CFROM CHANGES IN THE MONEY SUPPLY TO CHANGES IN REAL GDP

37 Exhibit 7: From Changes in the Money Supply to Changes in Real GDP © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 37 How does an increase in the money supply lead to an increase in real GDP? Increasing the money supply leads to lower interest rates, which promotes increased investment spending, which increases aggregate demand.

38 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 38 Countercyclical monetary policy Policy directives used by the Fed to moderate swings in the business cycle.

39 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 39 Reserve requirement The minimum amount of reserves the Fed requires a bank to hold, based on a percentage of the bank’s total deposit liabilities.

40 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 40 EXHIBIT 8RESERVE REQUIREMENTS (JULY 2006) Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington, D.C., July 2000).

41 Exhibit 8: Reserve Requirements (July 2006) © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 41 Do reserve requirements imposed by the Fed depend on the bank’s total deposits? Yes. Banks with more than $42.8 million in checking account balances must hold 10 percent of those deposits on reserve. Smaller banks only need to hold 3 percent of checking account balances on reserve.

42 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 42 EXHIBIT 9CHANGE IN THE DALLAS FED’S ACCOUNTS AFTER PROVIDING A $5,000 LOAN TO PFN

43 Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 43 If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply? Money held by the Fed is not counted in the money supply.

44 Exhibit 9: Change in the Dallas Fed’s Accounts after Providing a $5,000 Loan to PFN © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 44 Money held by the Fed is not counted in the money supply. PFN can loan out much of the money it borrowed from the Fed. If the Dallas Fed loans money to a private bank such as PFN, why does this increase the money supply?

45 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 45 Federal funds market The market in which banks lend and borrow reserves from each other for very short periods of time, usually overnight.

46 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 46 1.If a private bank has $5,000 in new reserves and the reserve requirement is 20 percent, then what is the maximum amount of new money supply that can be created from this $5,000? $5,000 × (1/0.2) = $25,000.

47 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 47 EXHIBIT 10CHANGE IN PFN’S ACCOUNTS AFTER RECEIVING A $5,000 LOAN FROM THE DALLAS FED

48 Exhibit 10: Change in PFN’s Accounts after Receiving a $5,000 Loan from the Dallas Fed © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 48 If the Dallas Fed loans money to a private bank such as PFN, does this generate a liability for PFN? Yes. The liability is the borrowed money that PFN owes to the Fed.

49 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 49 EXHIBIT 11FEDERAL RESERVE BANK OF NEW YORK DISCOUNT RATES: 1990–2008 (selected dates) Source: Federal Reserve Bank, New York, July 2008.

50 Exhibit 11: Federal Reserve Bank of New York Discount Rates, 1990–2008 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 50 What was the lowest discount rates charged by the New York Fed, and when did that take place? The New York Fed charged.75 percent on November 6, 2002.

51 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 51 Federal funds rate The interest rate on loans made by banks in the federal funds market.

52 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 52 Open market operations The buying and selling of government bonds by the Federal Open Market Committee.

53 Controlling the Money Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 53 2.If the Fed wanted to reduce the money supply, would it purchase or sell government securities? It would sell government securities. Money used to buy the securities from the Fed would leave the money supply.

54 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 54 EXHIBIT 12CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM PFN ($ millions)

55 Exhibit 12: Change in the Fed’s Accounts after Buying $10 Million of Securities from PFN © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 55 What was the change in the Fed’s liabilities after buying $10 million of securities from PFN? The Fed’s liabilities increased by $10 million due to a $10 million increase in PFN’s reserve.

56 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 56 EXHIBIT 13CHANGE IN PFN’S ACCOUNTS AFTER SELLING $10 MILLION OF SECURITIES TO THE FED ($ millions)

57 Exhibit 13: Change in PFN’s Accounts after Selling $10 Million of Securities to the Fed © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 57 If the Fed buys $10 million of securities from PFN, how much of the proceeds from this sale can PFN loan out? PFN can loan out all $10 million because these represent excess reserves.

58 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 58 EXHIBIT 14CHANGE IN PFN’S ACCOUNTS AFTER MARIA SELLS $10 MILLION OF SECURITIES ($ millions)

59 Exhibit 14: Change in PFN’s Accounts after Maria Sells $10 Million of Securities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 59 Suppose that the Fed bought $10 million of securities from a private individual (Maria) rather than from PFN. Would this still increase the money supply? Yes, but not by as much. If she deposits the check at the bank, the bank can loan out only $8 million of the new demand deposit. The other $2 million are required reserves.

60 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 60 EXHIBIT 15CHANGE IN THE FED’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES FROM MARIA ($ MILLIONS)

61 Exhibit 15: Change in the Fed’s Accounts after Buying $10 Million of Securities from Maria © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 61 If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts? The Fed’s assets increase by $10 million because it owns more securities.

62 Exhibit 15: Change in the Fed’s Accounts After Buying $10 Million of Securities from Maria © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 62 If the Fed bought $10 million of securities from Maria, and she deposited the $10 million check from the Fed at PFN, how does this change the Fed’s accounts? The Fed’s assets increase by $10 million because it owns more securities. The Fed’s liabilities increase by $10 million from clearing the check for PFN.

63 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 63 EXHIBIT 16CHANGE IN PFN’S ACCOUNTS AFTER BUYING $10 MILLION OF SECURITIES ($ MILLIONS)

64 Exhibit 16: Change in PFN’s Accounts after Buying $10 Million of Securities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 64 What happens to the money supply as a consequence of the transaction shown in Exhibit 16? By selling securities to PFN, the Fed reduces PFN’s reserves by $10 million. PFN is no longer in a position to loan that $10 million, which reduces the money supply.

65 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 65 EXHIBIT 17THE FED’S TARGET OPTIONS

66 Exhibit 17: The Fed’s Target Options © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 66 If Fed targets the money supply, as in Panel a, what countercyclical policy is no longer available to the Fed? The Fed can no longer control the interest rate, since the interest rate depends on the positioning of the demand for money.

67 Controlling the Interest Rate: The Fed’s Alternative Target Option © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 67 If the Fed targets the money supply, it cannot at the same time control the interest rate. Likewise by choosing to target the interest rate, the Fed loses control over the money supply.

68 Controlling the Interest Rate: The Fed’s Alternative Target Option © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 68 The Fed’s countercyclical monetary policy works either way, by changing interest rates or by changing the money supply.

69 Past Fed Governor Martha Seger Describes How the FOMC Works © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 69 According the Honorable Martha Seeger, what is the biggest difference between the Fed as textbook writers describe it, and how it really is? It is much more difficult for the Fed to make decisions than the process described by textbook writers.

70 Controlling the Interest Rate: The Fed’s Alternative Target Option © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 70 Margin requirements The maximum percentage of the cost of a stock that can be borrowed from a bank or any other financial institution, with the stock offered as collateral.

71 © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 71 EXHIBIT 18THE FED’S COUNTERCYCLICAL OPERATIONS

72 The Fed’s Countercyclical Monetary Policy © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 72 What was the Fed’s role in the addressing the Bank Crash of 2007? Both the Fed and government rushed to rescue the at-risk commercial and investment banks, buying up substantial quantities of their over-valued – and in some cases, worthless – assets.


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